What is Accounts Receivable Turnover and Why Does it Matter?
Accounts receivable turnover is a pretty important number for any small business owner to have a handle on. Essentially, what accounts receivable turnover refers to is how many times during the accounting period accounts receivable were collected. When considered within the context of small business, this number is a strong indicator of whether or not the business is doing a good enough job collecting on its sales. So the higher the number, the faster the accounts receivable are being collected. And of course, this is a good thing in terms of maintaining positive cash flow as well as taking into consideration the long term sustainability of the business. In this article, we will look at how you arrive at accounts receivable turnover calculation and why this is an important number to keep track of.
Understanding Accounts Receivable
First off, it is important to note that this number can be expressed in a few different ways. These include the overall accounts receivable turnover rate, turnover in terms of days, and accounts receivable turnover average is also sometimes calculated. It will depend upon what you are using this information for primarily.
Account receivable turnover among other metrics does help show how well a company is operating financially. If a business has a low turnover, this suggests that there could be some cash flow issues down the road; they, therefore, need to revisit how they are handling collecting on invoices. On the other hand, a high turnover rate is a positive indicator of a business. This suggests that either they are sticking firmly to their credit policies or, they're doing more in cash sales.
The goal is to aim for a higher accounts receivable turnover rate. Keep in mind too, with a lower rate, there is cost associated (both tangible and intangible/) withholding the receivables much longer than the organization should be. This again can directly impact cash flow negatively.
Accounts Receivable Turnover Formula
To be successful in any business you have to have a profitable accounts receivable turnover ratio. There is no getting around this. If you are unable to collect from customers and thus fail to get paid for services rendered or products purchased, you will be losing money. And if you are losing money, let's just say your business model is a flawed one that probably won't last very much longer. A profitable accounts receivable turnover ratio suggests that a company is processing their credit transactions in an efficient and timely manner. If there is a decrease in the accounts receivable turnover, this then means that more and more clients are paying late on what they owe.
The following formula is used to figure out the accounts receivable turnover: annual credit sales / average accounts receivable.
In this above, the average accounts receivable represents the average of both opening and closing balances for accounts receivable.
Below is an example of how you would arrive at accounts receivable turnover:
Let's say annual credit sales are 22,000. The accounts receivable at the beginning of the accounting period stand at 3400. At year's end, they are in 2000. So to factor accounts, receivable turnover would look like this:
22,000 / ((3400 + 2000/)/2/) = 8.1
The accounts receivable turnover rate is critical to understand. For many small businesses not being able to collect on credit sales will ultimately spell their demise. They need the cash coming in from accounts receivable to cover costs such as inventory, payroll, and operating expenses. Without it, they stand to fall behind and potentially be faced with having to make some difficult decisions. So keeping an eye on that rate can help the business gain a clearer picture of how it is performing in terms of collecting on past due accounts.
If Accounts Receivable Turnover Rate is Low
In the end, what matters is being able to collect on accounts receivable and thereby get the money that is owed you before it has a drastically negative impact on business operations. If in fact, the accounts receivable turnover is low, there are things you need to do and steps that need to be taken sooner rather than later to avoid more problems down the road:
- Revisit credit policies. Odds are there are ways you can tighten up those policies and thereby ensure that you have a better chance of collecting on unpaid invoices/credit. How many days are you allowing before payment is required? Perhaps you can shorten this period.
- By the same token, you could offer discounts for early payment and in this way incentivize your customers to pay as soon as they possibly can.
- Hand in hand with this, up to your late fees. If an invoice remains unpaid, charge a penalty and for however many days it still stands without being paid, add a hefty interest fee to this amount.
- There are a ton of technological and digital tools and resources out there that could also help you streamline the overall collections process. You will no longer be letting certain aspects of accounts receivable slip through the cracks.
- You might even think about hiring more staff specifically trained in the collections process. If you are losing enough money because of overdue payment, this could be worth considering.
- Additionally, if a customer is habitually late with a payment, you probably want to cut ties with that customer. Ultimately they are hurting your business more so than helping it.
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